Monday, 25 March 2013

Cyprus: Closing a Zombie Bank, Creating a Zombie Economy

The
March 25th Eurozone deal on Cyprus offers a EUR 12.5 billion bail-out of
Cyprus: EUR 7.5 billion in loan refinance for the government of Cyprus; the
remainder for the recapitalisation of the Cyprus banking system. Yet the
political mishandling of the negotiations by the Eurozone and its deliberate
attempt to destroy the international reputation of an EU Member State expose
the deep incompetence and deleterious nationalism still at work in Europe. It
casts grave doubts over the ability of the Eurozone to manage its far more
serious economic challanges. And it sows the seeds of the next financial crisis
in Cyprus.

In popular jargon, Cyprus Popular Bank (CPB) / Laiki is a zombie bank. Heavily
exposed to non-performing loans in Cyprus and Greece, and hit by the write-down
on Greek government bonds, CPB has been operating at loss for two years now.

Yet for 2 years, CPB
has been kept afloat by the European Central Bank’s Emergency Liquidity
Assistance (ELA) scheme. According to press reports, the ECB has pumped EUR 9
billion into Laiki; according to government contacts, the true figure is
higher, up to EUR 11 bln.

The ELA provided to
CPB and Bank of Cyprus (BOC) has been weighing heavily on the mind of the ECB’s
President, leading to his threat to cut off ELA as of this Monday, 25 March, to
Cyprus. More than anything else, this has shaped the “resolution” of the
present crisis.

Yet subsequent to
these rosy assessments, the credit situation of both banks deteriorated
rapidly. The first Greek PSI took place in February 2012, leading to the
write-down of EUR 206 billion in Greek Government Bonds, and creating losses
for BOC and CPB. In the third quarter of 2011, Laiki
had a nominal value EUR 3.1 bln of GGB on its books, while BOC had EUR 2.1 bln. 76%
of this value was written off, leading to the highest corporate losses in the
history of Cyprus. This was compounded by PSI 2, which wrote off most of
the remainder of GGB value, in December 2012.

It becomes clear that
the ECB/EBA assessments underpinning the stress tests were by that time thrown
out the window, as were bank assessments on NPL risk. It is also clear that the
decision to write down Greek government bonds, which was a European decision,
have led to the insolvencies of CPB and BOC.

2. CPB
Nationalisation

In May 2012, CPB was
nationalised after suffering record losses due to PSI 1. The government, by
that time faced with a massive deficit caused by the 2011 Mari explosion; a
deteriorating economic environment in tourism, shipping and property; an
unrestrained government spending.

By nationalising CPB,
the Cyprus government nationalised not only its loan book, but also it’s ECB
ELA obligations, which began in June 2012. Under ELA, emergency liquidity is
given to Cypriot banks with the ECB’s approval, but by the Central Bank of
Cyprus.

We do not know exactly
how much ELA is granted to either bank: neither
the ECB nor the Bank of Cyprus releases this information. Ostensibly this
is done to protect confidence in the banking system. To an investor or
depositor, however, this is an extremely negative event, as it makes an
assessment of true risk levels difficult.

Since Cyprus is in the
Eurozone, it no longer directly controls its Central Bank system. Unlike the US
or the UK, for instance, it cannot implement “quantitative easing” – expanding
central bank balance sheet and using the proceeds to buy government bonds or
other assets (e.g. mortgage-backed securities). As a result, a relatively
simple emergency bank funding line was mired in secrecy and ultimately to a
lack of accountability.

In the vote of the
Cypriot parliament, one Member stood up and said it was impossible for him to
vote for the Laiki nationalisation. The government had not released the true
figures, and had not made a proper accounting of risks and liabilities. That MP
has since been punished by his political party, consigned to “Siberia”. I am
proud to call that MP my friend: his remarks at the time have proved prescient.

Assessment of the
Current Bail-out Package

Based on information
released to press today, we understand that:

Cyprus Popular Bank is being liquidated.
Deposits under EUR 100,000 will be transferred to Bank of Cyprus.

Deposits above EUR 100,000 in both banks are
being frozen. The CPB deposits will be used in the liquidation; the BOC
deposits will be used in an equity recapitalisation of BOC. Depositors are
expected to lose 40% of the value of their deposits, but receive BOC share instead.

The Eurozone will approve the EUR 10 bln
bail-out, of which EUR 7.5 billion (approximately) will be used to refinance
and support government operations under separate loan conditionality, while EUR
2.5 billion will be used for banking operations.

Crucially, the ECB ELA credit line to CPB
passes to Bank of Cyprus.

What does this mean
for Cyprus?

On the face of it,
this package is an improvement over the previous package in classical economic
terms. It means that rather than punishing all depositors in Cyprus (at all
banks in Cyprus), it restricts the damage to larger depositors at the two
problem banks. By making these depositors liable for the specific problems in
these banks, it removes an element of systemic risk and places renewed investor
and regulator attention where it should be.

The liquidation of CPB
is a difficult decision, but a correct one. CPB has been a zombie bank for 2
years now, and has been avoiding a real restructuring—in no small part due to
political issues. Several political parties have wanted to avoid the political
cost of restructuring: this will now be settled with liquidation.

BOC will almost
certainly have to pass capital controls to avoid deposit flight. It is
uncertain whether capital controls will be extended to the rest of the island’s
banks, but in my opinion this is a certainty.

The EU has reaped
incalculable damage from the way it has handled this crisis, and caused
incalculable damage to Cyprus. EU politicians have gone out of their way to
criminalise and stigmatise both Russian businesses and “the Cyprus business
model”, calling it a haven for money laundering and other illicit activities.
In fact, no proof of money laundering has ever been provided; as stated in
other posts, the Cypriot tax system is legal and not the only “onshore” low-tax
jurisdiction in Europe. Malta, The Netherlands and other countries have a far
lower tax limit on certain types of transactions, while Russian holdings in
other EU countries are far larger.

Deposit flight and a
switch to other jurisdictions away from Cyprus by British, Russian and other
investors are now a certainty.

Rather than solving
the ostensible problem of money laundering, the German political hysteria on
this issue has simply caused it to metastasize to other countries. We note that
there is no regulatory trend in Germany or elsewhere to crack down on transfer
pricing in The Netherlands, to require Malta to change its corporate income tax
regulations, to regulate Luxembourg’s banking sector (several times the size of
the Cypriot one as a percentage of GDP), etc.

As a result, and
taking into account the impact of the structural adjustment programme in the
public sector, as well as renewed damage to credit availability in tourism and
property, and a range of other factors, we believe that the Cyprus GDP will
begin a painful process of contraction. In 2013, we believe this will reach a
5% GDP decline, and unemployment of 16-18%. The process will continue into 2014
and 2015.

Moreover, the roots of
this “bail-out” are now directly causing the next crisis in Cyprus, which will
be the need for a second bank recapitalisation, or possibly a liquidation of
the Bank of Cyprus. The BOC’s core problems remain non-performing loans (NPL),
poor trading conditions, and the GGB write-down. None of these have anything to
do with Russian money laundering or the other nefarious activities attributed
to Cyprus by the French and German finance ministers. However, by forcing
deposit flight from BOC (and deposit confiscation), the loan-to-deposit ratio
will very quickly worsen.

By very quickly, I
mean within 2 months, or whenever restrictions on deposit withdrawal ease. This
will lead to a requirement for yet another capital increase. An alternative
will be to transfer the NPL portfolio to a government-backed “bad bank”, which
bears its own peculiar set of risks in Cyprus.

It is not certain to
what extent the deposit confiscation will lead to a permanent loss of business
for Cyprus. There are numerous advantages to the Cypriot tax regime,
particularly for non-EU investors, which have not been touched by the bail-out,
and which, ironically, contribute to money laundering: the use of nominee
shareholders is an important one. Companies can continue to use Cyprus as a
jurisdiction, using three simple methods of managing risk:

a.Remove deposits from Bank of Cyprus into the
bank branches of more solid international banks. Cyprus has a range of banks
operating, including Societe General, Russian Commercial Bank, Barclays, and
others.

b.Continue a company in Cyprus, but hold the bank
account of this company outside Cyprus. Cypriot companies can hold bank
accounts anywhere in the EU, and anywhere outside the EU. This separates the
corporate capital flow from the national risk.

c.Use a “cash sweep” to transfer any funds
accruing in Cyprus to other companies, or bank accounts in other jurisdictions,
on a daily or weekly basis. This practise has already been implemented in
Greece successfully.

The Eurozone has
proven to be an emperor without clothes. The political hostility by Germany,
France and others; the lack of basic understanding of financial operations and
banking confidence; the very real effort to demonise Cyprus and Russia; the
stubborn insistence on seizing deposits; the deliberate threats of Eurozone
exit: these are not behaviours which will soon be forgotten.

Moreover, they are
behaviours which appear ingrained, and which have been fully transmitted to
national populations via what can only be described as a yellow press.

It is impossible to
see how the Eurozone will deal with its deep-rooted competitive distortions
given these political reactions. Rather than addressing an issue calmly and
rationally, they stir up the worse nationalistic instincts of a European
population already beset by economic crisis. Their “solutions” contain the
roots of the next crisis. If the Eurozone is unable to solve a EUR 17.5 billion
refinancing scheme, how will it solve the EUR 2 trillion national debt of
Italy?

There have been no regulatory measures passed
on “know your customer” requirements or corporate audits.

There have been no measures passed on Cypriot
banks to verify the sources of funds.

There have been no changes to the nominee
shareholder system in Cyprus, which permits the concealing of beneficial
company owners.

Cyprus is a Tax
Haven

There has been no change to the Cyprus tax
rate, which remains at 10% for non-resident companies and approximately 16.5%
for residents.

Cyprus retains its system of double tax
treaties, including the vital double tax treaty with Russia.

The other advantages of Cypriot law—light touch
regulation, an English language business system, remain.

The Cyprus Banking
Sector is Too Big

The forcible shrinking of the banking sector,
by liquidating CPB and causing deposit flight, will create the next round of
instability in Cyprus. Ironically, it will also shrink GDP. The final ratio of
the banking sector assets as a share of GDP may not change at all.

There have been no changes to the regulatory
authority or staffing of the Central Bank of Cyprus, which has directly and
indirectly been exposed to political interference, and has contributed to the
crisis by concealing the true financial picture of the Cypriot banking system.

There have been no changes to the secrecy of
ECB ELA and LTRO operations, which distort the market. There have been no
changes in the apparently arbitrary way in the which the ECB makes decisions.

The Cyprus Business
Model must Change

By attempting to destroy the offshore business
sector, German politicians may have convinced themselves that they have
“changed the business model”. If anything, I believe they have increased the
likelihood that after a few years, international investors will still be using
Cyprus, but moving their money to even less savoury locations.

There has been no replacement business model.
By destroying the international reputation and access to credit, German
politicians are doing nothing to help non-performing loans, Cyprus property,
Cyprus tourism or any other sector of the economy.

The entire spectacle
of European—and particularly German—decision-making in the case of Cyprus is
characterised by incompetence, hypocrisy, hysteria, and the loutish behaviour
of a schoolyard bully. Rather than solving any issues in Cyprus, it has
undermined the trust of international investors in Europe itself, and
established the conditions for the next financial crisis in Cyprus, which will
almost certainly relate to BOC recapitalisation in the face of deposit flight.

In Cyprus as in
Greece, the European leaders have done everything possible through their
statements and decisions to destroy international trust in a European Member
State. And as with the example of Greece, it appears that these same European
leaders have learned nothing.

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